State of Residential Mortgage Markets
Traditionally, when an individual buys or refinances a home, a lender has to obtain certain confidential information, such as income, employment, and credit history about that individual. The lender or the broker also obtains reports on the property such as title reports and an appraisal. The amount of manual labor required to process a loan has culminated into a typical 30-day lag from application to actual funding.
Even with the growth in online mortgage brokers, much of the mortgage industry remains paper-intensive. Although computers may generate some of the documents, the computers serve as glorified typewriters. Loans will only be considered complete and money will change hands when all the paper work has been completed.
Causes of Inefficiencies
The reason for this paper-intensive process is due to the secondary market in the residential mortgage industry. The residential mortgage industry is comprised of two major institutions: the primary market and the secondary market. The primary market, typically banks or financial institutions, lends money to consumers. The secondary market, such as Freddie Mac, purchases mortgages in large volume from the primary lenders. The secondary market investors then issue mortgage-backed securities for sale to the general public. This process provides liquidity for the lenders to make more loans to consumers.
For these mortgage-backed securities to be competitive, the secondary market investors guarantee the principal against default. Because of the guarantee, the secondary market investors are highly risk-sensitive.1 This translates into the need to verify information about the borrower (it will be appreciated by one of ordinary skill in the art that the terms borrower and applicant are used interchangeably). Since the primary lender will not make a loan unless it knows the loan is marketable to the secondary market, it accepts the verification guidelines from the secondary market investors. These guidelines mandate that the lender, and thus, the mortgage broker, obtain a myriad of personal information and property specific information. Traditionally, this information is collected manually. 1 For example, 73% or $533 billion of loans in the Freddie Mac's portfolio is at risk, i.e., Freddie Mac has taken primary default risk. The total reserves for loan losses was $768 million for Freddie Mac alone.
Industry Statistics
The latest statistics show that the residential loan market funded approximately $1 trillion annually in the last 5 years.2 The costs of manually processing each loan ranges from $1,500 to $3,000.3 Because of the manual labor, the costs per loan remain the same regardless of the number of loans processed and the loan amount. If the average loan were $150,000, there would have been approximately 6.7 million loans originated annually, and consequently approximately $10 to 20 billion spent on processing loans manually. 2 Mortgage Industry Directory, published by Faulkner and Gray. The actual amount fluctuates by a few hundred billion dollars, depending on various factors such as interest rates.3 The Internet Mortgage Report II, Focus of Fulfillment, by Posner and Courtian, Feb. 10, 2000, Morgan Stanley Dean Witter. See also W. R. Hambrecht analyses on E-Loan.
In addition, the secondary market devotes significant resources towards auditing the loans prior to the actual purchase from the primary market (i.e., “Quality Control”). Although there are no published industry statistics available regarding the costs of auditing the information by the secondary market investors, research has indicated that the costs are much higher than those incurred by the broker.
Primary Market-Traditional Processes
The avenues for financing in the primary market are mortgage brokers (“wholesale brokers”) and retail lenders. Brokers at retail lenders traditionally reside at the financial institutions' branch (“retail brokers”). Today, companies such as E-Loan (www.eloan.com) provide another avenue for consumers. Most of them purport to be on-line brokers, but many actually fund loans themselves. For example, 88% of E-Loan's portfolio was funded directly by E-Loan in 1999.
One of the functions of wholesale brokers is to match borrowers' requirements to various lenders' offerings. Retail brokers take orders from customers manually and match them to their financial institutions' offerings. Online brokers take orders from customers online. Once an application is taken, the broker obtains a credit report and a “pre-approval” from the secondary market. The secondary market investor pre-approves a loan conditionally, giving an indication to the broker and the borrower that the secondary market will buy the loan from the primary lender if all the conditions are met.
Once the pre-approval is obtained, the borrower can decide whether to proceed with the full application. If the borrower decides to proceed, a processor who works with a broker processes the loans by fulfilling the conditions. Hence the process is sometimes known as fulfillment.
Online brokers have come to realize that they need to invest in large back-end processing centers to fulfill the verification requirements, whereas traditional retail brokers already have these processors in place. Both have realized that the processing is an inefficient, unprofitable side of the mortgage industry. Unfortunately, no electronic infrastructure currently exists for any broker to plug their front-end applications into an automated verification platform.
Referring now to FIGS. 1A-1B, a conventional primary mortgage transaction flow diagram is illustrated. At step 101, a loan starts with a borrower entering information on a loan application and submitting it to a lender. The loan application may be a paper document which is completed by borrower and submitted to the lender. Some loan applications are available on a terminal at the lender's retail branch (i.e., PC-based), or on the Web. Such electronic applications mimic the physical forms used in the secondary market, e.g., Fannie Mae's Forms 1003 and 1008. All steps refer to those shown on the process flow diagrams.
The loan application is part of a lender's loan management system, also known as Loan Origination Systems (LOS), part of which is the front-end loan application. Lenders can have their own LOS, or can use commercially available systems from companies such as Keystroke (www.keystroke.com), Dorado (www.dorado.com) or GHR Systems (www.ghrsystems.com).
The information requested on the loan application falls into two major types: borrower specific and property specific. Borrower specific information typically includes:
Name of borrower (and co-borrower if applicable)
Social Security Number (co-borrower if applicable)
Current and former addresses
Current and former employers
Current income
Amount of funds/assets (savings, checking, investments, current house)
Amount of liability (mortgage, credit cards)
Current expenses
Where the down payment will come from
Property specific information typically includes:
Location of property (i.e., address, county)
Type of property (e.g., condominium or house, single or multiple family)
How it will be held (e.g., tenancy in common)
Who is the current owner and liens (i.e., title and clouds)
The loan application may not have the property specific information as borrowers can obtain a loan subject to property identification.4 The lender may also request photocopies of certain information, such as income tax returns and most recent pay stubs from the borrower at the time of the application to verify income and employment. 4 In certain geographic areas, e.g., the San Francisco Bay Area, a borrower needs to have a loan “pre-approved” before the borrower even seeks out a property to buy.
After the borrower provides his or her personal information to the lender, at step 103, the lender's system orders and receives credit reports. The credit reports can come from one of three vendors Experian, Equifax, and Transunion. These reports are requested and returned via facsimile or regular mail, or electronically via dial-up or the Internet. The credit report is then “scored” using proprietary algorithms, the most common of which is the FICO supplied by Fair Isaac and Company.
At step 105, the application form, and the credit report are passed into the automated pre-approval (AP) system such as LOAN PROSPECTOR from Freddie Mac. AP systems are applications provided to the lender by the secondary market to perform the “pre-approval” process.
At step 107, the secondary market returns a “preapproval” with certain lending conditions from their AP systems either electronically to the lender's loan management system or by fax. In situations when automated preapproval may not be appropriate, a human underwriter will review the applications and create the conditions. Lending conditions are action items that need to be completed in order for the lender to be assured that the loan will be bought by the secondary market buyer who pre-approved the loan once the lender funds the loan. These conditions have standardized codes. For example, one of the conditions may be the request for a preliminary title report. The AP also has a code identifying the loan so that when the loan is eventually sold, it can be matched back to the information already on the secondary market's AP database. Additionally, the lender's underwriters may add conditions beyond what is provided by AP.
Certain conditions, such as verification of employment, can be satisfied prior to property identification. In such a situation, at step 109, the lender orders verification of employment documents from a service provider, verification of income documents from another service provider, such as the Internal Revenue Service (“IRS”), and verification of deposits and funds documents from yet another service provider.
When the verification of employment is requested, the service provider must designate a human representative to actually review the request to ensure that the lender has all the information and borrower authorization needed to process the request.
In addition, currently, the IRS fulfills the verification of income manually. A borrower signs an income tax return release authorization form. In cases where income tax information is required, the broker or lender sends the request for prior year tax return to the IRS. The IRS will research the matter, and fax or mail back a copy to the requester.
The verification of deposits and funds is the process by which deposits at a bank or funds at a stockbroker can be verified. Currently, there is no centralized system or automated system to collect such information, although the banking industry may be in the process of standardizing on the use level 3 digital certificates, such as those provided by Digital Signature Trust (DST, www.digsigtrust.com) to facilitate this verification.
At step 111, the borrower identifies a particular property and provides the address to the lender. Then at step 113, the lender will request property specific information. In particular, the lender will request a preliminary title report, typically by calling a title company and faxing or mailing information regarding the property to the title company. The lender will also recommend an appraiser to appraise the property. The lender will contact the appraiser by telephone, who will set up an appointment with the seller or the seller's agent to visit the property and prepare an appraisal. The appraisal is then prepared by completing a form and faxing or mailing the document to the lender. Some appraisal reports may be electronically mailed in a fixed display format (e.g., Adobe Systems' PDF). In addition, the lender will also set up an escrow account.
The lender compiles the property specific information as it is received at step 115 and evaluates the information at step 117 to determine whether the borrower's criteria match the lender's guidelines. If the package lacks information needed to satisfy the pre-approval, at step 119, the lender requests clarification from the service providers. If the package contains all the information needed to satisfy the pre-approval conditions after the processor review, the normal course of action is to send the loan package to the underwriting department at step 121.
A human underwriter reviews the loan package for accuracy and completeness at step 123 and at step 125 makes judgments as to whether additional verification needs to be done based on the lending institution's underwriting rules. If certain information contradicts what the applicant stated in its application (e.g., single family house versus multifamily house), the loan may be sent to AP for re-approval. New conditions may arise and steps 107 through 125 may be repeated in part.
If the loan package has errors, the documents are returned to the lender at step 127 for further processing. If the documents are acceptable to the underwriting department, it will issue loan documents at step 129. Once the documents are prepared, the lender notifies the escrow agent that the documents are ready to be signed. The escrow agent then notifies the borrower to go into the escrow office to sign the documents. Then, the borrower manually signs a litany of paper documents and returns them to the lender at step 131. A notary witnesses the signature and signs the documents as well.
One of the problems with manual signatures is that unauthorized use of the signed documents may arise. Processors or lenders may instruct borrowers to sign the documents but not date them. Once the borrower leaves, these lenders are then able to make photocopies of the signed documents and add dates at their discretion without the borrower's knowledge or consent. The lender or processor can then submit the loan documents to service providers on subsequent dates and multiple times to monitor a borrower's financial status. For example, every two years the lender may complete and resubmit the borrower documents requesting IRS information by just using a photocopy of the borrower's loan documents and filling in a more recent date.
Even if the borrower signs and dates the loan documents, a lender or processor is still able to “white out” the date field and resubmit the loan documents to service providers on subsequent dates and multiple times, without the borrower's knowledge or consent.
By dealing with paper transactions, there is ample opportunity for a lender, processing agent, or other intermediary to manipulate the documents. Typically, lenders and processing agents are paid based on a commission or fee received when the borrower's loan is funded. Thus, these entities have an incentive to close deals. With such incentive, these entities may manipulate data in order to ensure the deal closes. For example, information in an appraisal may be changed in order to allow the borrower to satisfy a loan-to-asset ratio. Thus, a need exists to prevent intermediaries from manipulating data provided by the service providers and data provided in the loan documents after they have been signed by the borrower.
Once the documents have been signed, at step 131, the lender sends the documents to the underwriting department at step 133 for the underwriter to perform a final manual review (if they choose to). If the documents fall within underwriting guidelines, the underwriter instructs the funding department to wire the money to the escrow agent.
At step 135, the escrow agent will record the title deed, the loan documents, and other liens as needed. This is typically performed manually by having the title company send a messenger to the county recorder office. The county will then issue a recordation number. Based on the escrow instructions, the escrow officer will disperse the funds to the parties, such as: current lien holders (i.e., paying off existing mortgage, if any), seller, lender (points), fire insurance, and the title company.
FIG. 2 illustrates a conventional funding process between the lender and the secondary market, known as the forward sale. At step 201, a mortgage (lender) bank negotiates a rate commitment for a specific volume of a specific loan product from a conduit bank (i.e., secondary market investor). For example, the mortgage bank may negotiate a rate commitment for $10,000,000 of 30-year fixed rate loans. The mortgage bank pays the conduit bank fees for the rate commitment. The commitment contract between the mortgage bank and the conduit bank specifies the type of loan product, such as a 30-year fixed loan; the length of commitment, such as 6 months; the fees to be paid by the mortgage bank; penalties for failure to meet the commitment; and the negotiated time for settlement, which is typically four weeks from the time the loan is funded and submitted to the conduit bank to the time the conduit bank pays the mortgage bank.
The long time for settlement has many disadvantages. First, the mortgage bank is burdened with low cash flow. Prior to settlement the mortgage bank has provided funds to the borrower to complete the loan. It is not until settlement that the conduit bank reimburses the mortgage bank for those funds. Thus, during the interim the mortgage bank may be low on cash. Second, the mortgage bank is also burdened with an interest rate risk. If the interest rates go up during the settlement period, the mortgage bank may have to obtain cash elsewhere at a higher interest rate to cover the loans to new borrowers.
Typically, a warehouse bank issues a line of credit to the mortgage bank. Drawing upon its warehouse line of credit at a warehouse bank to complete the loans to borrowers, the mortgage bank generates and closes loans at step 203 as illustrated in the flowchart of FIG. 2. At step 205, the mortgage bank disburses cash to the property seller via title/escrow.
At step 207, the mortgage bank's secondary market desk maintains an inventory of loans issued to the borrowers on a spreadsheet to ensure compliance with the commitment contract. In addition, at step 209, loans are manually reviewed for quality control by the quality control (“QC”) department before being sent to the conduit bank. Since the manual review process is very time consuming, typically the QC department is only able to do a sample (e.g., 10%) review of the loans. Thus, a significant number of loans are not reviewed. Moreover, in addition to being time consuming, the processes generate a lot of paper because the mortgage banker must retain a copy of the documents that are sent to the conduit. Until the loans are accepted and paid for by the conduit bank, the mortgage bank is the lender of record and must maintain the documents.
At step 211, after each loan is closed and quality controlled, paper loan documents are sent to the conduit bank. At step 213, the conduit bank performs its own due diligence including matching the internal database for fraud, checking the accurate and completeness of documents, and performing a re-underwriting. Since the volume of documents is large, these steps can only be done through random sampling. Such random sampling may include ten percent of the loan documents at best, and the conduit bank's due diligence may take 30-45 days to complete.
If the loan documents are satisfactory, the process proceeds to settlement at step 215. At this step the conduit bank transfers the money to the mortgage bank's warehouse bank to replenish the mortgage bank's warehouse line of credit. The time depends upon the contractual agreement between the mortgage and the conduit banks. As discussed above, there are many disadvantages to such a long settlement period. Thus, a need exists to shorten the settlement period and limit the manual quality control process.
An alternate conventional funding process, known as the flow sale, is illustrated in FIG. 3. In such process, there is no volume or interest rate commitment between the mortgage banker and the conduit. The only commitment is that the conduit will provide an interest rate to the mortgage bank on a spot basis, and will accept loans underwritten in accordance with the conduit bank's guidelines for that interest rate. A lender receives a request for a rate lock on an interest rate from a borrower at step 301. At step 303, the mortgage bank looks up rates from a conduit (investor) bank and provides the available rates to the borrower at step 305. Once the mortgage bank receives confirmation of the interest rate lock from the borrower at step 307, the mortgage bank locks in the interest rate lock with the conduit at step 309. This alternate conventional funding process then follows steps 209, 211, 213, and 215 of the conventional forward sale process discussed above with reference to FIG. 2. As a result, this alternate conventional funding process has the same undesirable long settlement period.
Yet another conventional funding process, the bulk sale, is illustrated in FIG. 4. The forward and flow sale processes discussed above with reference to FIGS. 2-3 constitute the majority, in terms of volume, of the loans for lenders. This bulk sale process is typically used for “alt-a” and sub-prime loans for borrowers with higher risk profile. These loans can be more profitable than prime loans and can be used to increase overall portfolio return. The bulk sale differs from the forward and flow sales in that there is no agreement between the mortgage bank and any conduit before the loan is funded. In a bulk model, the mortgage bank underwrites the loan in a generic enough manner that it can be sold to a few conduit banks. The mortgage bank funds the loan from its own line of credit, and then tries to find a buyer for these loans.
The bulk sale process begins with a step similar to step 203 of the forward sale lending process illustrated in FIG. 2 when a mortgage bank underwrites and closes a loan, drawing upon its warehouse line of credit at a warehouse bank to complete the loan. The process continues with steps 205 and 207 of the forward sale lending process.
After step 207 of the forward sale lending process illustrated in FIG. 2, the process continues with step 401 of the flow chart illustrated in FIG. 4. At this step 401, the mortgage bank packages a set of bulk loans and finds buyers, sending them a spreadsheet of these loans and offering to sell the loans at a certain price. At step 403, conduit banks review loans before purchasing and perform due diligence. For loans that are satisfactory, the conduit bank wire transfers money, at step 405, to the mortgage bank's warehouse bank to replenish the mortgage bank's warehouse line of credit. This settlement period usually takes four to six weeks. Unsatisfactory loans are either rejected or negotiated for a lower price.
The conventional lending process is an expensive and time consuming paper intensive process. Thus, a need exists to automate the information gathering and auditing processes of the primary market and secondary markets and to reduce the settlement periods.